Miners as the Decentralized Mint and Payment Processors

Miners are the shiny objects in the Bitcoin industry. The term “miners” is used as an analogy to explain the incentive alignment in Bitcoin. Miners find a block, secure the transactions within it, and are rewarded in bitcoin for the service. As long as miners get paid, the incentive for miners is to move forward on the blockchain and keep processing transactions.

Miners as the Decentralized Mint

It doesn’t exactly cost money to mine. More directly, it cost CPU power, hardware, and electricity. All of which are priced differently depending on your level of access. Hardware manufactures in China and entities with politically cheap or stolen power have a reduced financial cost and advantage in mining. The enforcement of a real-world cost to rewriting history on the blockchain is what secures the forward movement on the chain. Because the cost to reverse those transactions, and rewrite history, is not guaranteed and even more expensive than moving forward.

This process of incentivizing miners to convert real world resources for a digital reward brings new coins into circulation and functions as the decentralized mint.

By convention, the first transaction in a block is a special transaction (called the “coinbase” transaction) that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation since there is no central authority to issue them. The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.

Satoshi NakamotoBitcoin: A Peer-to-Peer Electronic Cash System

The problem with the term “miners,” is that without any further explanation, people assume that without the bitcoin reward, miners will stop mining and processing transactions entirely. With no one mining blocks, this would mean a freeze of transactions on the blockchain. But this isn’t the complete story. The incentive system that rewards miners with newly minted shiny bitcoins is just one function of miners.

When all the new coins have been minted the system will be deflationary and the miners primary function will be to process payments and the term “miners” won’t make much sense at all.

Miners are Also The Payment Processors

Explained from the perspective of miners getting a reward, people are led to believe that once the reward runs out miners won’t get paid. Some go as far to brand this as a security flaw in the system itself. The term “payment processors” conveys (if only slightly) that these nodes are providing a service and that they need to be paid to stay in the business of securing the network.

The truth is that Miners already exists as payment processors. Miners aren not only paid by the block reward but also by fees. Its only in the past several years that the price of fees have been been a significant factor.

The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation-free.

Satoshi NakamotoBitcoin: A Peer-to-Peer Electronic Cash System

If You Want to Incentivize Miners to Keep Processing Transactions, You Have Two Options:

Perpetually inflate the currency to reward miners.

This requires that the currency has a value;

And simultaneously lessens the strength of bitcoin as a currency through increased inflation.

Or Incentivize the miners with fees.

This also requires that the currency has value;

But it also increases the value of each bitcoin by limiting its supply;

While lessening the strength of bitcoin as a payment processor, because it potentially becomes more expensive to spend bitcoin as the cost of fees rise with the increasing network hashrate.

The Bitcoin network is designed to slowly diminish the miners’ reward over time and rely on fees because the block reward is more of a block subsidy.

The Block Reward is a Block Subsidy

The block reward will end.

Roughly every four years the reward is decreased by half until all the coins have been mined. You can see below how the inflation or supply of bitcoins has correlated with the price in dollars.

Don’t take this distinction for granted.Everyone forgets about the halving.

The number of people that have been using bitcoin for years, when it was at a relatively low value, with no fees, still clutch their pearls when fees are “introduced”. The truth is that the fees are not new, the cost of fees never had the opportunity to be high, since the value of bitcoin itself was low. How fees are calculated is the subject of another post entirely. Suffice it to say high fees on the Bitcoin network have been used to justify forking the currency, the creation of altcoins, and was once the core of the heated blocksize debate for a number of years.

Exactly how fees are calculated is worthy of its own full explanation. The important take away here is to understand why fees and inflation are tradeoffs. And why bitcoin shifts towards fees instead of inflation, and why that makes it a more useful currency than payment processor.

Is Bitcoin a Currency or a Payment Processor?

It’s both, but it is undeniably better at one than the other.

The role of miners is not just to shower themselves in newly minted bitcoins, but also to process transactions. When all the coins are mined, the role of miners will solely be to process payments for fees. When that time comes the value of bitcoin has to be high enough to make it possible for miners to process transactions profitably.

The fact that miners in the Bitcoin system are dedicated payment processors does not mean that the system is or should be optimized for payment processing. The system is optimized for its long term value as a decentralized currency. The fundamental trade-off between fees or no fees is the choice between Bitcoin as a currency or as payment platform. And the tilt towards a blockchain as a payment platform usually comes at the cost of continued inflation.

Fees are not ideal. But people pay them, and the value of bitcoin grows. Why? Because the value of a currency with real scarcity, and without a central authority is worth the price we pay for it.